Musings on Economics, Finance, and Life

The Problem with Tax Expenditures

Last week, Len Burman published a provocative op-ed suggesting that President’s Obama idea of freezing non-security discretionary spending amounts to “chump change” and that if he wants to make real budget improvements the President should propose to freeze tax expenditures (i.e., all the various preferences in our famously complex tax code). By Len’s calculations, such a freeze would increase tax revenues by $3.5 trillion over the budget window, 14 times as much as the $250 billion in spending reductions from the narrow spending freeze.

Len is right to focus attention on tax expenditures. They involve big money, distort our conception of the size of government, often disproportionately favor the affluent, and receive too little oversight.

He’s also right that they deserve special attention when Congress decides that it wants to increase tax revenues. As Len says in the interview: “Cutting tax expenditures is a much better way to do this than raising marginal tax rates since the former tends to improve economic efficiency by reducing economic distortions — for example, among different kinds of investments — while the latter increases the economic cost of taxation.”

Of course, there are some complications. In addition to the obvious political challenges, tax expenditure cutters face another problem: agreeing on what provisions should actually be characterized as tax expenditures. One could, of course, just use whatever definitions the Treasury and the Joint Committee on Taxation use. But analysts do not agree on which provisions are really spending programs in disguise.

Some cases are easy. Tax credits for using ethanol-blended motor fuels are clearly spending programs run through the tax code. But then there are items like the 15% tax rate on capital gains and dividends. That rate is scored as a tax expenditure in the current system because 15% is lower than the rates on ordinary income. It wouldn’t be viewed as a tax expenditure, however, by analysts who believe that a consumption tax, rather than an income tax, should be the lodestar for judging tax policies. My point is not to take sides on that issue, but just to point out that there is sincere debate about which items labeled as tax expenditures should be viewed as hidden spending programs and which as good tax policy.

In response to one question, Len raises the idea of subjecting all tax expenditures to annual reauthorization as one way to rein them in. I appreciate the desire for greater oversight, but I find this idea worrisome. We are already cursed with a tax system in which an enormous number of provisions are scheduled to expire. That creates needless uncertainty, placing a real burden on businesses and families and often undermining the very intent of the tax provisions. As a case in point, consider the research and experimentation tax credit, which Congress extends every year or two. That’s absurd. If the credit is good policy, it should be enacted on a permanent (or, at least, prolonged) basis so that it provides a clear signal to firms that engage in R&E. Conversely, if it’s bad policy, we should kill it. Revisiting it every year will just enrich lobbyists, distract legislators from more important issues, and weaken any incentives it might create.

I expect that the same holds true for many other tax expenditures. Some deserve to be enacted for prolonged periods to accomplish their goals. Some deserve annual review. And many deserve to be killed.

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8 Responses

Re: the research and experimentation tax credit, which Congress extends every year or two. That’s absurd. If the credit is good policy, it should be enacted on a permanent (or, at least, prolonged) basis so that it provides a clear signal to firms that engage in R&E.

If that subsidy, instead of being a tax expenditure, took the form of an (actual) expenditure (i.e., “spending”), then applying that same argument of yours, wouldn’t you have to advocate changing that subsidy from part of the discretionary budget to an entitlement just like, say, Medicare?

Longer, slightly-off-the-wall answer: As a blackboard exercise, here’s the circle we want to square. Assume for the moment that you believe the R&E credit is good policy. That should mean that you believe that it really provides an incentive to R&E efforts. If so, then you should want some degree of “permanence” in the R&E credit to make the incentive effective. If I am considering a new R&D lab, I am more likely to take the R&E credit into account if it seems permanent (by which I really mean persistent).

On the other hand, you want to force oversight and review of the credit. So may be tempted to make it sunset every five years. But then you’ve really only provided 2.5 years of “permanence” on average over the 5 year life (since it only has 4 years of persistence after one year, etc.).

So what you really want, at least on a blackboard, is a policy that enacts the R&E credit for the next five years, and then renews it one year at a time with five years advance warning. (Remember, I didn’t say this was possible.)

So there you have the compromise: Make it mandatory for the first five years and then give it to the appropriators each year thereafter. But with the requirement that they have to make up their minds five years beforehand.

Interesting solution to the dilemma. So should I assume that your ideal would be the same if it remains as a tax expenditure? That is, if it remains as a tax expenditure within the tax code, your ideal would be for it not to remain as is (not subject to the kind of oversight and review you mention), but rather to have a 5-year sunset on a rolling basis, with the 5 year period renewed each year (or rejected)?

And if that subsidy would be substantively the same whether as a tax expenditure or as a “spending” subsidy, would you have a preference between the two (based on the considerations I’ve listed in my comment below and/or others)?

I would prefer it (and other tax expenditures that subsidize particular, explicit choices and related situations) take the form of “spending” subsidies, all things considered, and in particular considering the irrational greater receptivity of tax expenditures (vs. “spending” subsidies) on the right and overall, due to the mistaken view of such tax expenditures as akin to (or at least in the same category as) tax rate cuts from an economic and ideological perspective, rather than a “spending” subsidy that would substantively be the exact same thing. And my point isn’t that we should try to create a bias against subsidies, just that they should be transparent and actively justified. If the supposed justification is positive externalities — that it’s best to make other taxpayers pay more in taxes if John Doe or Company X chooses to buy Y or do X, because it’s in everyone’s collective best interest — then that case should have to be made. If it’s a “fairness” justification, again, the case should have to be made.

And I realize that, conceptually, one could view some individuals having lower tax rates applied to them on income based on level or type of income as a “subsidy” of a sort, but it is of a different nature (in terms of incentives, economics, “fairness” etc.) than subsidies for particular, explicit choices and related situations (getting a mortgage, sending a kid to college, having a child or even getting more of one’s compensation in the form of health insurance). And if someone objects to limiting the term “tax expenditures” to what I’m talking about, ok, then we have two categories of “tax expenditures” and I’m speaking of one of them that is categorically different from the other.

[Donald — please let me know if comments should be shorter than this one. I wanted to express this completely]

If we are thinking of “tax expenditures” as subsidies for particular choices and related situations (e.g., buying a home with a mortgage, having a child, sending a kid to college) – as opposed to a lower tax rate for, say, capital gains income vs. ordinary income — there is a fairly clear distinction, and there isn’t any inherent, substantive difference between a tax expenditure subsidy (or reduction thereof) and a “spending” subsidy (or reduction thereof), as long as the same things happen on the same basis (i.e,. you do X – e.g., buy a home, have a child, send a kid to college, and the result is that you’ll end up with $X more as a result of the presence of this tax expenditure than you would without it, and other taxpayers will, sooner or later, have to pay more to make up the difference [net of dynamic effects, which would apply equally to the equivalent “spending” subsidy]). Aside from timing differences, there is no substantive difference between paying the government $20 and getting a subsidy of $5 back vs. just paying the government $15. And there would be no rational reason to prefer one over the other.

However, they are treated differently politically because many people erroneously, irrationally perceive an inherent difference and thus a subsidy that would be the same either way (substantively speaking) is often treated differently in our political process based on which form it takes, even though the only substantive differences being the label and inconsequential bookkeeping. Most notably and most problematic, folks on the right in particular are generally much more receptive to subsidies in the form of tax expenditures than they would be to the equivalents in the form of “spending” subsidies that were exactly the same in terms of what happens and on what basis and in all related incentives, macroeconomic effects, various effects on different people, the role of government in the economy and in people’s lives, likelihood of the subsidy’s creation/growth/maintenance/reduction/elimination, etc.

That’s why Obama expected applause from Republicans when, in his State of the Union address, he bragged:

we … made health insurance 65 percent cheaper for families who get their coverage through COBRA; and passed 25 different tax cuts.

Now, let me repeat: We cut taxes. We cut taxes for 95 percent of working families. (Applause.) … We cut taxes for first-time homebuyers. We cut taxes for parents trying to care for their children. We cut taxes for 8 million Americans paying for college. (Applause.)

[Obama looks at Congressional Republicans and says to them] I thought I’d get some applause on that one. (Laughter and applause.)

Fiscal conservatives should view the above no more favorably than the translation below:

we … borrowed and spent more to provide subsidies to make health insurance 65 percent cheaper for families who get their coverage through COBRA; and passed [almost] 25 different increases in deficit-financed spending subsidies.

Now, let me repeat: We increased borrowing so we could increase spending subsidies. We increased borrowing so we could increase spending subsidies for 95 percent of working families. (Applause.) … We increased borrowing so we could increase spending on subsidies for first-time homebuyers. We increased borrowing so we could increase spending on subsidies for parents trying to care for their children. We increased borrowing so we could increase spending on subsidies for 8 million Americans paying for college. (Applause.)

[Obama looks at Congressional Republicans and says to them] I thought I’d get some applause on that one. (Laughter and applause.)

But this (irrationally) different political treatment doesn’t mean that the two are substantively different in themselves, inherently. They are not substantively different from each other. They are the same. And they both ARE substantively different (in incentives, effects, ideology, economics, etc.) from a tax rate cut.

So how would/are each (tax expenditure subsidy vs. “spending” subsidy, or the creation/increase/decrease/elimination thereof) be treated differently politically, and with what harm/benefit? Some key questions that occur to me are:

1) Which is more likely to be created/increased or reduced/eliminated or kept unchanged? Related considerations: Which is generally viewed more favorably and/or less unfavorably by the public (tax expenditures generally viewed more favorably, particularly by folks on the right)? Which is more conducive to a “tragedy of the commons” dynamic?

2) Which is more transparent to the public and thus perhaps more likely to reflect the public’s wishes and priorities and which is more likely to have a corrupting influence? (I’d say all these #2 considerations favor “spending” subsidies over tax expenditure subsidies)

Then there is completely separate question of one’s policy preference (meaning a general preference and a preference in individual cases of particular subsidies) between fiscal policy containing subsidies of either form (tax expenditures; “spending subsidies) vs. just determining tax liability via tax rates and not including subsidies among “actual” expenditures, or moving more toward such fiscal policy by reducing subsidies of either form, considering factors such as:

A. Answers to Questions #1 and #2 above and any others related to differences in political treatment.

B. Which increases/decreases economic efficiency rather than distorting economic behavior in a way that reduces aggregate well-being and the well-being of most people? Which imposes greater explicit costs in terms of administration, compliance (e.g., accounting services), etc.

C. Which is “fairer”?

D. Which is more conducive to incentivizing behavior with positive externalities with a positive net effect (net of any “costs”/drawbacks of that approach)?

And insofar as particular tax expenditures are created/increased/reduced/eliminated, would each particular change in tax expenditures (or a set of particular changes) affect our overall fiscal policy adversely in terms of “fairness”, incentives, economics, etc., such that we would want to change some other element(s) of fiscal policy (e.g., tax brackets and rates; spending in some area; etc.)

Don, Thanks for the thoughtful reply. Here is what I wrote, basically concurring with your analysis:

Don Marron’s point that investment subsidies are probably made less effective by their temporary nature is surely right. It would make sense to make the R&E credit permanent, especially since it has such overwhelming bipartisan support that there’s no chance of ever allowing it to expire.

Don’s also right that there are some serious issues about definition of tax expenditures. For example, some believe that the appropriate base should be a consumption tax rather than an income tax. Measured against a consumption tax baseline, for example, the taxation of capital gains would be considered a negative tax expenditure, whereas the reduced rate is considered a positive tax expenditure under the income tax base. However, there is a great deal of overlap between the income and consumption tax expenditures, and those provisions would be a great starting point for enforcing budget discipline.

I also couldn’t resist to responding to Grover, but I won’t waste space on your blog with that.

[…] tax subsidies for health care. If you view many tax subsidies as close equivalents to spending (as I do), this is a very important metric. It would indicate, for example, that if you increase health […]